A biotech lesson for big pharma mergers

Pfizer’s $100 billion offer for rival AstraZenecais proof that big drug makers are once again seeking out big mergers. It’s a way for them to gain market leverage as governments clamp down on health-care spending. But the more interesting story—and one Big Pharma could learn from—is the bull market in young, lean biotech companies and their initial public offerings.

More than 40 biotech companies went public in 2013, with another 30 IPOs in the first four months of this year. A total of $5.3 billion has been raised over that time, according to BioCentury’s BCIQ database. It’s from this capital that a sector nonexistent three decades ago now counts about 400 public companies with a collective market capitalization of almost $700 billion. The biggest winners have become mammoth companies in their own right, worth many billions of dollars.

The lesson for more established companies like Pfizer comes from how the biotechs have used the capital markets to advance new drugs. History tells us that their original ideas often don’t pan out. But companies ultimately succeed because they’re able to keep top research teams intact and learn from early setbacks. They pivot from dead ends to taking new, more-productive paths. Most of all, they’re able to continue to tap capital in the public markets to finance operations through early scientific stumbles while pursuing the long-term research necessary to develop pioneering drugs like Genentech’s Herceptin, which cuts in half the risk that a particularly aggressive form of breast cancer will recur after surgery.

But when rival pharmaceutical companies like Pfizer and AstraZeneca merge, it is often research and development teams that get trimmed, along with more mundane overhead costs. Lost scientific productivity is often a casualty of the cost-cutting. Research teams get broken up. Scientists reassigned. Others quit when they’re forced to move.

Meanwhile, keeping research teams intact has been the key to success in biotech, and research is where much of the IPO capital is ultimately channeled. Drug researchers are working with an increasingly discrete set of novel biological targets, such as cell receptors that can turn off the growth of cancer cells, that are the source of today’s precision medicines. When research teams make new discoveries, keeping scientists together long enough to capitalize on a breakthrough is the difference between success and failure.

When you look at the most successful biotech outfits, none of them achieved success on the science and drugs they originally set out to pursue. Genentech focused its initial efforts mostly on drugs for the heart. Yet over time it found its scientific methods were best suited to pioneer new drugs for cancer.

Gilead Sciences started out developing drugs based on long strands of genetic material called RNA. In time its researchers realized that it was the components of RNA (called nucleotides) and not the RNA itself that made good medicines. The company lost money for 15 years before it became profitable, and now has a market cap of more than $100 billion.

Genzyme started out with a genetic-testing business and a separate idea to use fermentation processes to develop industrial chemicals, among other things. Its research team realized that the fermentation techniques could also be used to design protein drugs against the same genetic diseases it was learning how to test for. That led to the development of Ceredase, the first effective treatment for Gaucher disease.

Yet even in the booming biotech sector, the ability of early-stage life science companies to tap public markets and raise the capital that will carry them through these twists and turns of science is becoming less certain. The cost of satisfying regulators at the Food and Drug Administration has increased at every stage of drug development. But on a proportionate basis, those costs have risen much faster in the crucial, early stages of drug development.

At the same time, ObamaCare is creating uncertainty about how much programs like Medicare and Medicaid will pay for new medicines. For investors in biotech IPOs, this means that the “value creation stage”—when they put big valuations on new drug programs—is being pushed further out, often not until drugs reach the final stages of development.

The net effect? FDA requirements front-load the cost of developing drugs, making it more expensive to get under way, while uncertainty created by government payers makes it harder for companies to raise capital during the crucial early stages. This is a recipe for destroying the capital-markets model that created America’s unrivaled biotech sector.

These trends couldn’t come at a worse time, with big companies like Pfizer increasingly relying on biotechs to develop new drugs that they will eventually market. This allows them to focus on global distribution and regulatory filings, along with running the late stage clinical trials that require huge resources.

What should Big Pharma learn from all this? First, that the most successful mergers are those where companies buy thriving biotechs and let their research teams continue as independent, competitive units. When Roche bought Genentech, it kept the company’s research and early development teams separate from the Roche organization allowing Genentech to maintain its unique and productive culture.

That may be the enduring outcome of this wave of mergers, a final reordering of the two industries, biotech and pharma. The big drug makers will increasingly focus on activities that benefit from scale, and subcontract the scientific work that doesn’t.